Amid Brexit Turmoil, U.K. Contemplates a Labour Party Victory

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Lina Saigol and Rupert Steiner, Financial News

Jan. 22, 2019 11:08 a.m. ET

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Ever since the U.K. prime minister’s crushing defeat of her EU withdrawal plans on January 15, political commentators have speculated that one route out of the country’s Brexit deadlock might be a fresh general election.

Despite the defeat of the opposition party’s January 16 attempt to force one, the talk remains in the air. On January 18, the New Statesman magazine reported that several government ministers had told their local party organizations to prepare for an election in February.

If an election were held, the opposition Labour Party, under left-wing leader Jeremy Corbyn, would have a chance of winning it. Recent polls have shown the two leading U.K. parties are closely matched.

But Labour does not just have an alternative, mildly softer policy on Brexit (it wants the U.K. to remain in the EU’s customs union). More concerning for the markets are its wider economic policies, which include nationalizing key industries, placing workers on company boards and handing employees up to 10% of company shares.

Labour would have to borrow tens of billions of pounds to finance its nationalization plans. A report from NERA Economic Consulting has warned that nationalizing U.K. utilities alone would cost British taxpayers around 182 billion pound sterling ($236 billion).

A Labour comeback could also weaken sterling which would make imports more expensive for domestic producers, hitting U.K. mid-cap stocks.

A program of nationalization and higher government spending has sparked concerns among some fund managers that it would destabilize U.K. stocks and lead to a flight from U.K. assets.

The prospect of a Labour-led government came second only to Brexit as the greatest challenge for business leaders in a poll carried out by London First and BritainThinks in August. The researchers spoke to more than 100 chief executives, managing directors, chief financial officers and board members at companies across the U.K. which employed 50 people or more.

Here, FN looks at which sectors of British business would be the most impacted under a Labour government.

Water companies

Water is the first industry Labour has said it will bring back into public ownership if it is elected. Since the sector was privatized by Margaret Thatcher’s Conservative government in 1989, it has been criticized for rewarding shareholders and executives while failing customers and society.

During that period, the nine companies which, together with Wales’ publicly-owned Dwr Cymru, supply most of the water in England and Wales have amassed £47 billion ($60 billion) in debt and shareholders — mainly private equity groups — have made £56 billion ($72 billion) in dividends, according to a study by Greenwich University’s Public Services International Research Unit. Meanwhile, consumer bills have risen 40% in real terms.

However, nationalization of water companies could have serious adverse consequences for pension funds which have significant investments in them. Anglian Water, for example, is part owned by several pension funds including the Greater Manchester Pension Fund and the London Pension Fund Authority.

Thames Water, the U.K.’s largest water company which is owned by Macquarie Bank, posted a sharp fall in half-year profits to £67.7 million ($87.6 million) from £129 million ($167 million) for the same period a year earlier. In September, it said it would invest £11.7 billion ($15.1 billion) to improve infrastructure as part of its next five-year business plan.

In December, Moody’s said the outlook for regulated water and wastewater utilities in the U.K. for the next 12 to 18 months remains negative on continuing regulatory, political and public pressure.

Defense and engineering

In 2016, Britain decided to renew Trident, the country’s nuclear deterrent system, and build four new submarines at a cost of £31 billion ($40 billion).

Corbyn is a longstanding pacifist, and has made clear his personal opposition to the U.K.’s possession of nuclear weapons. However, in 2017, the wider Labour Party — which includes unions representing defense workers — voted to back the renewal of Trident. Corbyn has said he will respect the decision.

BAE Systems, which is building the new submarines alongside Rolls-Royce and
Babcock International,
have described the nuclear deterrent programme was one of the world’s “most complex engineering challenges”.

If Corbyn halts the program, it would potentially remove a large revenue stream of business for these three companies. BAE Systems, for instance, has signed a £1.6 billion ($2.1 billion) contract with the Ministry of Defence to build the seventh of the so-called Astute hunter-killer submarines. Shares in BAE have lost more than 15% of their value during the past 12 months.

A Corbyn-led government could also introduce a more protectionist agenda when it comes to mergers and acquisitions of strategic U.K. assets.

Last year, Melrose’s £8 billion ($10.4 billion) hostile bid for GKN, the U.K.’s third largest FTSE 100 engineering company, prompted Corbyn to say he will intervene to prevent hostile takeovers which threaten to destroy Britain’s industrial base if elected.

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Energy

Labour’s manifesto states that “private energy providers overcharged customers by £2 billion in 2015” and it would seek to “regain control of energy supply networks” and “transition to a publicly owned, decentralised energy system”.

It plans to set up a Public Ownership Unit “immediately” on entering government, and that in some cases investors might not be compensated.

Most at risk would be National Grid which delivers electricity and natural gas to the fast-growing U.K. and American markets. At 787.80p the market has heavily discounted the risk of an attempt at renationalization which broker Berenberg estimates at 150p a share.

It wrote in a note from October : “In a worse-case scenario, it would be hard for Parliament to condone paying anything less than a network’s stated RAV [regulated asset value]. Consequently, National Grid’s share price appears to be discounting the worst case.”

It says politics is totally overshadowing the firm’s growth opportunities on both sides of the Atlantic.

SSE, the Scottish energy company headquartered in Perth, is also exposed to similar risks but on the upside offers the potential of inflation-matching dividend growth over the next few years.

Transport

Labour wants to take each rail franchise back into public ownership when the current contracts expire. This gradual nationalization would not instantly affect rail operators, but it would mean firms would lose the opportunity to run franchises in the future.

It also only becomes an issue if Labour delivers on its promise. Given how prominent it was in its manifesto, and how popular it is with the public, it would be hard for the party to back down.

The three FTSE firms most affected are
FirstGroup,
Go-Ahead and Stagecoach. FirstGroup, which began as an operator of bus services, owns the operating companies Great Western Railway and Transpennine Express, and also runs South Western Railway in a joint venture with China’s MTR.

Go-Ahead controls two franchises, TSGN (Thameslink, Southern, Great Northern) and Southeastern, which are both run by a company called Govia. This is a joint venture between Go-Ahead and French-Canadian transport operator Keolis.

Stagecoach, meanwhile, runs the East Midlands franchise and has partnered with Virgin to jointly run the West Coast inter-city rail franchise.

Go-Ahead, through Govia controls 22% of the U.K. rail network. compared to Firstgroup at 20% and Stagecoach at 10%. But the companies also have broader operations, with U.K. rail only a portion of their businesses.

All three are also extensively involved in the provision of local bus services in the U.K. Labour has set out a policy to re-regulate bus services across the country, which would not remove franchises from private companies but would restrict them. It has also proposed lifting the current ban on local government councils from running bus services themselves.

Stagecoach is the transport company most exposed to the U.K. regional bus market, controlling 26%. Firstgroup has 21% and Go-Ahead 11%.

Outsourcing firms

These are the firms that have been drafted in to run prisons, forensic science, construction, health and parts of education.

Labour has said it would stamp out contracts being “hoarded” by companies engaged in “risky behaviour”. It has threatened to take back control of contracts if firms do not meet standards on tax compliance, environmental protection and the timely payment of suppliers.

The listed firms most at risk include the world’s largest security firm G4S, which has contracts to run prisons in the U.K.

G4S has had some high-profile setbacks that might make ministers less well-disposed to the firm. Last year the Ministry of Justice was forced to step in and take immediate temporary control of Birmingham prison in the wake of a damning report into conditions.

However, the U.K. is a relatively small part of G4S’s global business, being home to just 7% of its workforce.

At Capita, which provides recruitment and financial services, half of its business comes from the public sector: it is used by the NHS to manage doctors’ pensions, for example. It too has suffered setbacks: it delivered a new online recruitment system to the British Army which was 52 months late and £182m over budget.

Nevertheless, the company specializes in tech-led solutions, and the government will continue to need cost effective means of managing large-scale projects. And the other half of Capita’s business originates in the private sector, with clients including Volkswagen, O2, and PWC.

Housebuilders

In its election manifesto, Labour promised to build a million homes within five years, which would be a boost for housebuilders. Half of these would be for council or housing association tenants. Corbyn has said 100,000 new social homes will be built annually, and the Conservative government’s Right-to-Buy policy will be scrapped.

The big U.K. housebuilders vary in both size and performance. But looking at their recent earnings updates offers a good guide to the leaders and laggards.

Taylor Wimpey
is on track to meet full year expectations despite “wider macroeconomic uncertainty” and is looking at returning £600 million ($777 million) in dividends, which is equal to just over 18p a share, to investors in 2019.

The shares offer a prospective yield of 13% but special dividends are a significant contributor and could easily be cut if conditions turn sour, Hargreaves warned.

Persimmon, the U.K.’s second biggest housebuilder, expects full-year pre-tax profit to be modestly ahead of market consensus as it continues to benefit from robust employment levels, low interest rates and a competitive mortgage market.

The FTSE 100-listed company is focused on building cheaper family homes in northern England, the west midlands and Wales, which protects it from a tightening at the top of the U.K. housing market.

The company has also opened its own brick and tile factory near Doncaster to make 80 million bricks a year as well as roof tiles to hedge against a shortage of building materials.

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